The uncertainty of what constitutes a “financial interest” in virtual currency could expose taxpayers to willful conduct claims if they incorrectly answer the new cryptocurrency checkbox on Form 1040, according to a practitioner.

“One of the problems that we have with this question is the imprecision of the definition” of financial interest, Zhanna A. Ziering of Caplin & Drysdale said during a February 27 Strafford webinar titled “New IRS Cryptocurrency Guidance on Hard Forks and Airdrops.”

Ziering noted that a cryptocurrency question has been added to the 2019 Form 1040, Schedule 1, “Additional Income and Adjustments to Income,” requiring taxpayers to answer yes or no: “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

The question is similar to the one added several years ago to Schedule B of Form 1040 asking taxpayers if they have an interest in any foreign financial accounts. The government has had much success in proving that a taxpayer willfully failed to file a foreign bank account report by checking “no” to that question, Ziering said.

Murky Definition

The IRS appears to be “planting the seed” for taking a similar approach on willfulness with the cryptocurrency checkbox, Ziering said.

“If you represent ‘no’ and sign the return, and it’s subsequently discovered that you did indeed have reportable virtual currency, then the IRS has an argument, ‘You should have known — you signed the return and intentionally misled the IRS,’” Ziering explained.

However, the IRS hasn’t provided an explanation of what the phrase “acquire any financial interest in” means for cryptocurrency purposes, Ziering said.

“To sell or exchange [virtual currency] is clear, but to acquire a financial interest is where it gets murky,” Ziering said. She noted that the instructions to Schedule 1 state that a transaction involving virtual currency includes “the receipt or transfer of virtual currency for free (without providing any consideration), including from an airdrop or following a hard fork; an exchange of virtual currency for goods or services; a sale of virtual currency; and an exchange of virtual currency for other property, including for another virtual currency.”

“But it does not define ‘financial interest’ or ‘acquire any financial interest,’” Ziering said.

Part of the problem is that the phrase “financial interest” was borrowed from the offshore question on Form 1040 Schedule B, but “that is a term of art for those purposes,” Ziering said, noting that taxpayers wondering how to answer the offshore question can look to the regulatory definition of what it means to have a financial interest in a foreign account.

But for the cryptocurrency checkbox, “it’s used very vaguely,” Ziering said. “I can imagine situations where it could be all-encompassing and where it would not.”

She noted that Treasury’s Financial Crimes Enforcement Network has said that for now, its position is that taxpayers who hold cryptocurrency in a foreign exchange aren’t required to disclose that information on an FBAR. A letter from the FinCEN director included in the Government Accountability Office’s February 12 report on cryptocurrency said that FinCEN “will coordinate with the IRS to determine the best approach to provide clarity to the public regarding the application of” the FBAR rules to cryptocurrency.

However, on the related issue of whether taxpayers with offshore cryptocurrency holdings must file Form 8938, “Statement of Specified Foreign Financial Assets,” the IRS hasn’t issued any formal guidance yet, Ziering said.

An IRS official told Tax Notes in November 2019 that the agency can’t give a definitive answer without looking at the specifics of how an exchange operates. The official said that taxpayers who don’t know if they need to file a Form 8938 should ask themselves whether the cryptocurrency is being stored in a financial account maintained by a foreign financial institution, as those terms (“financial account” and “foreign financial institution”) are defined in the form's instructions.

Ziering pointed out that, as highlighted in the GAO’s report, taxpayers may not know if the account that holds their offshore virtual currency could be considered a depository or custodial account.

“You could end up in a situation where you have an asset that would be reportable on Form 8938, just out of an abundance of caution, but isn’t reportable on the FBAR,” Ziering said. “At some point, we’ll get more guidance and more clarity on this issue.”

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